Blog Series: The World Through One Economist’s Lens (Part 3)

As the world grapples with the economic impact of the COVID-19 pandemic, traditional policy tools are being stretched in real time and in dramatic fashion. Alternative views and methods are being formed with potentially long-dated ramifications. From emerging forms of economic theory to potential consequences of fiscal & monetary policy action, we are at a pivotal point where near-term decisions have compounding implications on future outcomes.

We felt it was time to start a multi-part series addressing various topics that will likely shape the future of sustainable economic development. Our goal here is to be short, concise, and to spark dialogue. As always, please feel free to comment & share as well as subscribe to our newsletter for more content.

.   .   .

PART THREE: IF A LITTLE IS GOOD, THEN MORE MUST BE BETTER

On the back of the latest Federal Reserve meeting and monthly inflation indicator, we felt it was time to discuss the increasing role that central banks play in our economy and the tools they rely upon to meet their objectives. In prior episodes of this series (Part One & Part Two), we discussed factors affecting the sustainability of mounting sovereign debt and how monetary and fiscal policy would need to work in concert to navigate these uncertain times.

We established that while interest rates remain low, debt service is more manageable, and therefore more debt could be sustained, so long as government spending was used to promote future economic growth. Now we turn our attention to how central banks use various forms of monetary policy in an attempt to regulate the economy for growth while providing stability.

To start, in the United States and most developed countries, monetary policy is distinct from fiscal policy in that it is set forth by the central bank which is intentionally left independent from government control. This is done for good reason as numerous examples of hyperinflation have been witnessed throughout history by countries who did not uphold this principle. Essentially, with monetary policy as its doctrine, central banks are free to act as they deem necessary and prudent to meet their broad objectives for the economy as a whole. In the case of the U.S. Federal Reserve, those statutory objectives are:

• Maximum employment
• Price stability

The rationale behind the dual mandate is to strike a balance between interrelated forces within the economy. Accommodative monetary policy is meant to promote economic expansion by creating favorable financial conditions (i.e. low interest rates, expanding money supply, high stock market, etc). As the economy expands, broad incomes rise, and production of goods must also rise to meet increasing demand.

All else equal, this necessitates additional hiring by employers and unemployment falls as more people enter the workforce. This cycle continues until such point that maximum employment is reached. Maximum employment is defined by the Federal Reserve as, “All Americans that want to work are gainfully employed” and is estimated to be between 3.5% — 4.5%. Under this condition, economic activity is at its maximum sustainable rate of production. But the economy is circular in that, your purchase may be your neighbor’s income, and so on. At this point of the cycle, since production is maxed out, increases in demand exceeds supply. This is known as an overheated economy and rising prices (inflation) becomes a concern. Enter the second mandate: Price stability.

By price stability we are really referring to setting reasonable expectations regarding the future price of something. Consumers often consider what, when, and how much to spend based on trends in prices for the goods they desire. Under normal conditions, prices tend to move gradually higher over time. The change in price may be noticeable to consumers but not drastic enough to dramatically influence behavior. This is considered as price stability. Think of a time when you felt as if you had to purchase something NOW or be forced to pay a much higher price for waiting just a couple of days or weeks. In the U.S., we have seen some of this in the housing market from time to time but not much else since the late 1970s.

Now imagine further if you had a strong expectation that prices were likely to fall significantly in the future. What then? Well, you would likely delay your purchase in order to get a better price in the future. These two examples help to explain why expectations of future price movements influence consumer behavior — either can become a self-fulfilling prophecy that compounds over time.

Typically, central banks are more concerned with a downward spiral of prices because, as each consumer delays spending to capture the expectation of lower future prices, economic activity grinds to a halt. Given that the consumer is responsible for around 70% of U.S. economic activity, this phenomenon would have grave implications. For reference, Japan has become the poster child for the negative effects of deflation that have stalled their economy for decades. For this reason, central banks have resorted to increasingly more aggressive forms of accommodative monetary policy since the Great Financial Crisis (GFC). As a result, the U.S. money supply has increased from $6T to over $18T, while aggregate GDP has only increased from $14T to $21T over that same time period. More recently, to combat the financial stresses caused by the COVID-19 pandemic, the Federal Reserve increased the U.S. money supply by $3T since March alone — a staggering level of stimulus by any measure.

So how does a central bank use monetary policy to create favorable financial conditions in order to meet their objectives? There are multiple aspects of the economy that a central bank seeks to manipulate — all in the broad measure of influencing the money supply and inflation expectations. We’ll address each of these in turn, how they are intertwined, and discuss the ramifications of various policy actions.

Many developed economies rely heavily on the banking system as a conduit for the flow of money. Most people in those economies hold the cash that they intend to use for future expenditures in an interest-bearing checking/savings account. Additionally, we also know that households consider borrowing as part of their expenditures.

Because banks primarily earn profits through lending and are mandated to hold daily cash reserve requirements, banks are ideal suitors for controlling the money supply in circulation. Because of this dynamic, a primary tool used by central banks to influence money supply is prevailing short-term interest rates. For many years now however, the compensation that depositors receive throughout the developed world has been declining. This is a deliberate act by central banks through monetary policy to stimulate spending. The idea here is that if depositors are not being highly compensated for saving their money, then they will naturally resort to spending it.

This policy action has gone so far that some developed countries, most notably Japan, have resorted to negative short-term interest rates to induce spending and investment. Theoretically, this would imply that a depositor would have to pay the bank interest in order for the bank to hold money in an account for them. In fact, lowering interest rates does have a stimulating effect on the economy but mostly by way of increasing spending by borrowing. Since interest rates are so low, purchases that are typically financed with debt over multiple years are more approachable; namely: housing, education, etc. This is because the largest determinant in what consumers are willing to pay for these large ticket items is the total monthly expense. As interest rates move downward, the monthly expense does as well. This means that the consumer can afford a higher overall price.

The problem here is that the supply of these items is relatively fixed in the short run. As demand for these financeable items increases, the price paid does as well. Following this phenomenon through time is the inflation rate at work. Have you noticed the price of housing and education rise over recent years? These items far outpace the rise in price levels of other items where purchase decisions are less influenced by borrowing costs. Would you find yourself asking how much you would be willing to pay for yogurt if you could finance it cheaply for multiple years? Not likely.

Case in point: COVID-19 brought with it the deepest recession any of us have seen in our lifetime and yet, because Federal Reserve is forcing interest rates down, the U.S. housing market is breaking historical records in terms of sales and prices.

So now that we have demonstrated how economic activity and inflation may be induced, albeit not unilaterally, by lowering interest rates. Perhaps greater control and precision is needed to deliver upon the central bank’s dual mandate? Have no fear, central banks have resorted to more tricks in recent years: Quantitative Easing (QE) and Forward Guidance.

QE refers to the central bank actively purchasing financial assets, typically bonds issued by their own government, in order to inject money into the financial system. Unlike consumers however, large businesses typically achieve most of their borrowing by issuing bonds instead of borrowing from a bank. Since these bonds often pay a fixed rate of interest, this additional demand introduced by the central bank has the desired effect of lowering prevailing yields and borrowing costs. This has a simulative effect for businesses much in the way same as it does for consumers. That is as it relates to expenditures that are usually financed with borrowing, namely large capital expenditures, M&A activity and share buy backs. The draw back with QE is that it only stipulates the amount of assets that will be purchased by the central bank. While interest rates will fall as a result, they may not do so in a precise manner or uniformly. Enter the next phase of central bank interest rate manipulation: Yield Curve Control (YCC).

Effectively, YCC is a promise by the central bank to purchase any and all outstanding bonds within the policy’s targeted maturity at such a price so as to ensure that the bond yield(s) do not exceed the policy’s targeted rate. This establishes a cap on interest rates and allows for accommodative borrowing costs for longer term lengths. Theoretically, this provides the central bank with more control over prevailing interest rates with varying maturities. YCC raises the stakes of the game, however. In order to ensure that the precise interest rate is achieved and maintained indefinitely, market participants must believe that the central bank is committed to the endeavor. For example, as opposed to simply injecting a prespecified sum of money into the economy through a normal QE program, an effective YCC program requires the central bank to inject whatever money is necessary to hold interest rates low for however long it takes to achieve their goal. This uncertainty as to the lengths that a central bank will be required to go puts them in a precarious situation to say the least.

While YCC is not yet being utilized by the Federal Reserve, the Bank of Japan (BOJ) has pledged to maintain its bond yield(s) of up to ten years in maturity at or below zero percent since 2016. Japan’s rationale was the same as we have described throughout: increase the money supply by inducing borrowing which will increase economic activity and ultimately escape from the deflationary spiral of falling prices. Unfortunately, this aggressive monetary policy has had fleeting success for Japan. Economic activity for the last four quarters has been declining along with aggregate prices. While there are many rationales for this, it appears that the BOJ’s fortitude is being called into question. Enter Forward Guidance.

Forward Guidance by a central bank simply refers to clearly setting expectations and having market participants believe them. As fears of deflation returning mounted, the BOJ revised its Forward Guidance at the beginning of 2019 to reflect its commitment to restoring inflation by stating, “The BOJ expects short- and long-term interest rates to remain at present or lower levels as long as needed to pay close attention to the possibility that the momentum toward achieving its price target will be lost.” Members of The Federal Reserve have also recently commented on the importance of Forward Guidance as a necessary tool to meet their objectives. Chicago Federal Reserve President Charles Evans has been quoted as saying, “A lot of this is convincing…people in the markets and the public that we’re really in it to win it.” Since central banks have increasingly engaged in more aggressive forms of monetary policy (i.e. QE and YCC) to manipulate interest rates, any disbelief by the market that the central bank is less than committed would induce massive turbulence and distortions. 2013 Taper Tantrum anyone?

So what lies ahead? As we have established, inflation is often the consequence of an overstimulated economy that has reached maximum employment and has become overheated. Currently in the United States we have an unemployment rate in excess of 8%. This is far greater than the pre-pandemic level of 3.5%. With the U.S. having officially entered into a deep recession, any inflation concerns would ordinarily be benign. However, the latest Consumer Price Index report revealed that monthly inflation for July was 0.6%. The last time we recorded a monthly inflation number that high was in 2018. The significance here is that, at that time, we were on the verge of the longest U.S. economic expansion in history. It is also the last time that the Federal Reserve tightened monetary policy to rein in inflation and raised interest rates to reduce the money supply. The rationale was to slow down the economy since the target range of maximum unemployment had been achieved. We do not have such a luxury today. You may ask yourself, ‘How could we have such high inflation when the economy is clearly far below the Federal Reserve’s target of maximum employment?” Simply put, Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon…”

Hopefully we achieved our mission for this episode by effectively explaining how central banks attempt to meet their goals of regulating the economy through monetary policy. Although what was presented here is a rather simplistic analysis of the delicate relationship between policy measure(s) and both intended and unintended consequences, the global financial system is vastly more complicated. In a statement from their meeting in July, the Federal Reserve affirmed that interest rates would stay as they are until they are “confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.” We will take them at their word, but the question remains, when, if ever does it stop? In our next episode, we will explore the effect that monetary and fiscal stimulus has on the status of the US dollar, our trading partners, and expectations for the future.

.   .   .

‍